Friday, June 4, 2010

Bonds versus Stocks

Ordinary investors are still not alert to the danger of buying bonds. The potential to get negative returns from bonds, even when the issuing entities remain healthy, is well-known in theory. However, the long bull market in bonds, corresponding to the gradual decrease in inflation during the last several decades, has led to forgetfulness. That is why I wrote Bonds, Danger! on April 4, 2010.

Since then a number of articles have appeared reminding investors of this issue. But the recent Greek bond and Euro mini-crisis caused bond interest rates to drop, and prices to rise, yet again. In a double contradiction, this kind of sovereign debt crisis reminds us of the danger of bond defaults. Even the U.S. government could default on its bonds.

Today there was a very good CNN Money article on this issue, Bonds: Avoid the Next Great Bubble by Paul J. Lim. You should read it, unless you already understand this issue.

It is funny that the Greek bond crisis (it was a crisis for Greek; its effect on the global economy was mainly psychological) would cause people to dump stocks and buy bonds.

In military history it is a truism that, all other things being equal, the generals who fight the previous war lose. Apparently using the latest economic weapons, like mortgage derivatives, does not guarantee success either. It is important to know what has changed and what has not changed. Bonds were safe in the recent past, but they are not now. Stocks of good, profitable, growing companies are safer because they are a better value right now.

The theory that you should balance your portfolio between stocks and bonds is a good one. In a bull stock market it forces you to sell some of your stocks and buy bonds. In a bear stock market it should also force you to sell some of your bonds and buy stocks. The problem is that in a bull market there is incentive to delay selling stocks, and in a bear market there is an incentive to stay in bonds. So most investors wait until what would have been a smart move becomes a stupid one.

All that said, I'd rather be mainly in stocks than in bonds right now. The main risk to stocks is another macroeconomic downturn. There are two risks to bonds: the risk from rising interest rates and the risk that an economic collapse could cause bond defaults.

There is also the psychological risk with stocks. If you need to sell your stocks today, so sorry, you are going to get a bad price for them, or at least for all but a select few. There are not enough buyers in the market to price most stocks appropriately. This situation could continue for some time. But if the companies you own are profitable, and if you are investing long term, this should not be a problem. My companies, anyway, are earning good profits and socking away cash. The ones that are not paying a dividend could pay one. They can also use their cash to buy back stock, or to expand their business. A profitable company with growing profits can be worth a lot more than today's auction price would indicate. That is how you prosper: buy value for less cash than it is worth. [I also own more speculative companies that have not yet earned a profit, like Dendreon. That is a whole different category, not suitable to ordinary investors.]

Could I be wrong? Of course! An atomic war could start tomorrow. But atomic war has been a possibility every single day of my life. I prefer to bet on high probability events, like the continuing global economic recovery. Within that recovery some companies will be winners, some losers. That is why I like technology companies with global reach. Greeks may be buying less electronic devices right now, but they are more than compensated by Chinese and Indians buying more electronic devices.

1 comment:

  1. Looking at Bonds vs stocks 2010, both have their own unique risk and reward profiles. In order to maintain proper diversification, you absolutely must own both, although in what proportion depends on your own specific circumstances.